Future thrills

Paul Krugman has shown the effects of economies of scale on trade patterns and on the location of economic activity.

How are we affected by globalization? What are the effects of free trade? Why do increasing numbers of people flock to large cities, while rural areas become depopulated?

In the context of both foreign trade and economic geography the objective is to explain what goods are produced where. Theories of economic geography also attempt to specify the forces whereby labor and capital become located in certain places and not others. Foreign trade is based on differences among countries: technology, labor, capital, but at the same time intra-industry trade has expanded. Krugman introduced an entirely new theory of international trade. It was intended to explain the occurrence of intra-industry trade and was based on an assumption of economies of scale whereby mass production diminishes the cost per unit produced.

Consumers appreciate diversity in their consumption and we see a growing number of brands. It seems as if we opt for diversity and variation in our consumption.

According to this model, each producer, working under increasing returns to scale, becomes more or less a monopolist in terms of his own brand, even though he is subject to sharp competition from other brands.

Such a model can be used to show that foreign trade will arise not only between countries which are different, but also between countries which are identical in terms of access to technology and factor endowments. Moreover, it can be demonstrated that extensive intra-industry trade will occur. In fact, it becomes advantageous for a country to specialize in manufacturing a specific car, and to produce it for the world market, while another country specializes in a different brand of car. This allows each country to take effective advantage of economies of scale, thereby implying that consumers worldwide will benefit from greater welfare due to lower prices and greater product diversity, as compared to a situation where each country produces solely for its own domestic market, without international trade.

Economic geography deals not only with what goods are produced where, but also with the distribution of capital and labor over countries and regions.

A comprehensive theory of location of labor and firms is developed. Krugman assumes that although trade is possible, it is obstructed due to transport costs. But otherwise, labor is free to move to the country or region which can offer the highest welfare, in terms of real wages and diversity of goods. Firms’ location decisions imply a trade-off between utilizing economies of scale and saving on transport costs.

This was evolved into the so-called core-periphery model, which shows that the relation between economies of scale and transport costs can result in either concentration or decentralization of communities.

Regional imbalances arise and most of the population will be concentrated in a high-technology core, whereas a small minority will inhabit the periphery and live off agriculture. Such a mechanism could underlie the explosive urbanization witnessed today throughout the world, with rapidly growing megacities surrounded by increasingly depopulated rural areas.

This is not necessarily the only possibility, however. Under different conditions the forces which give rise to decentralization will dominate. This promotes somewhat more balanced development.

(Extract Nobel Prize paper 2008)

This entry was posted on Monday, January 5th, 2009 at 12:30 pm and is filed under General. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.